On The Call: Morgan Stanley CEO James Gorman

On The Call: Morgan Stanley's CEO on the 'black box' of Federal Reserve stress tests

Last month the Federal Reserve announced results of its so-called stress tests, the annual check-ups they put the big banks through to see how they'd fare in a severe recession.

Morgan Stanley passed. It asked for, and received, permission to buy the rest of Morgan Stanley Smith Barney, the retail brokerage it jointly owns with Citigroup. Other banks asked for permission to return capital to shareholders through actions like dividends and share buybacks.

Like other banks, Morgan Stanley also released results from its own version of the stress test, meant to approximate the Fed's as much as possible. According to Morgan Stanley's own models, its capital levels would be higher than what the Fed predicted in a severe recession.

The banks don't know the exact methodology the Fed uses. The banks complain that the tests aren't transparent, but the Fed says it doesn't want the banks to have the answer key to the test, so to speak.

The topic came up on Morgan Stanley's first-quarter earnings call Thursday. This excerpt has been edited for clarity and length. CCAR is the government's name for the stress tests, meaning Comprehensive Capital Analysis and Review.

CREDIT SUISSE ANALYST HOWARD CHEN: "Speaking of CCAR, your own test results came in a bit below that of the Fed. I just wanted to get your thoughts on what you believe drove that difference. What's in your control to bridge that gap going forward? How does it impact timing and quantum of the next stage of capital return?"

MORGAN STANLEY CHIEF FINANCIAL OFFICER RUTH PORAT: "Our understanding is that the Fed has its own model, which relies on historic data. Given we've invested meaningfully to increase the quality and consistency of earnings, there have been charges that have obviously been flowing through the (profits and loss statements) that are negatives in the historic financials, but on a go-forward basis, we've eliminated drag and improved the quality and consistency of results. So, it's understandable there's a difference between the two, if one forecast is based on historic results and the other is looking at a fundamentally different business mix. We don't know the extent to which those historic results in the Fed model were adjusted.

"So, it's hard to know precisely how the models are different. ...We are continuing to accrete capital and we think that that does continue to give us degrees of flexibility."

MORGAN STANLEY CEO JAMES GORMAN: "The difference between what we submitted and believe the models should throw out, and what ultimately came out of the black box that is the CCAR process — the difference was narrower than what it was last year. We've obviously gotten better at it and I think it was, relative to some of the other firms out there, frankly not a very surprising result. So we will play this forward. Our focus now is getting Smith Barney."